Sunday, July 27, 2008

Ilargi: An IMF working paper was published this week (see article below), and has gotten little attention -which is a bit suspicious-.

If we take the "gloomiest" numbers from the paper, US homes were overvalued by 20% in early 2008, and will come down by that much, as well as swing well below their "equilibrium level" That all seems bad enough news for the uninitiated. However, I don’t think it’s overly realistic. There are assumptions that apply a kind of optimism that doesn't seem to have much going for it it except for hope, or perhaps fear of fear.

I haven’t had time to read all 31 pages, a PDF version of which is here at IMF, and it's full of data. But what I have seen raises a few questions.

The paper indicates that housing prices will come down 25-30%, worst case, peak to trough. Still, I know that prices rose by over 100% in the US since the turn of the millenium, and hence should come down by 50% to come back to the same level. And I would expect a violent "swing" downward, an extra 10-15%, in a move I like to call "oscillation”.

So where does this discrepancy in numbers come from? Is it just inflation? I think this graph from the paper may give part of the answer:

As you can see, it assumes foreclosure starts will decrease quite dramatically from the 2nd half of 2008 onwards. With the resets in option-ARM and Alt-A loans yet to start climbing for real, and with a look at numbers presented this week by RealtyTrac, I have, to put it charitably, serious doubts about that decrease.

The same goes for the presumption that home prices will start rising, albeit merely in relative terms, from Q1 2009, and that the inventory sales ratio will fall.

A second graph from the paper seems to contradict the first one in a substantial manner. While it plots the real price itself (vs the growth rate in prices in graph 1), the differences are inexplicably large. There is some leveling off, but very little.

Looking at the paper and its graphs, I don’t see any reason to change my prediction that US home prices will come down by 80% or more (I have left inflation out). There are three forces involved in applying downward pressure on prices:

The 50% drop that gets prices back to "equilibrium levels" (not my favorite term, but that’s another story).

The perhaps the most perverse factor, the decrease in available credit that is hitting the markets, and will get stronger -The Increasing Decrease-. In the UK, mortgages approvals fell over 60% from last year, and that will happen in the US as well (and all over the world). There is no more credit to be lent out.

The US (and to a lesser extent EU) housing booms of the past decade were based on a model where collateral was deemed unimportant; credit was plentiful. Neither money down nor income statements were needed, because loans were packaged and sold as smortgage-backed ecurities: the risk went somewhere else. That model is dead. And when there are no buyers, because nobody can get a loan, prices will keep falling.

And then it’s time to realize that a house is only worth what you can actually get for it. Or even what your neighbors can get for theirs.

The downward spiral of U.S. housing prices still has a way to go and homes were overvalued by between 8 percent to 20 percent in the first quarter of this year, according to research by an International Monetary Fund economist published on Friday.

In his report "What goes up must come down? House price dynamics in the United States," IMF economist Vladimir Klyuev used several economic techniques to determine by how much U.S. home prices are overvalued.

Klyuev drew from a government study of single-family home prices to conclude that values were "around 14 percent above equilibrium in the first quarter of 2008, with a plausible range of 8 to 20 percent." His research showed that home prices became considerably overvalued from 2001 and while the housing market has started to correct itself, there is still a long way to go.

U.S. policy-makers are now trying to guide the housing market into a soft-landing after a five-year run-up in home values that ended in 2006. The report also said that it is likely home prices will swing well below their equilibrium level before they start to recover.

Klyuev's research included data gathered by the U.S. Office of Federal Housing Enterprise Oversight which regulates mortgage-finance companies Fannie Mae and Freddie Mac and collects purchase price data. Klyuev analyzed the dynamics of home prices and found the inventory-to-sales ratio the most important driver of changes in property values in the short run.

"Starts in foreclosures, which obviously add to inventory, seem to also exert additional downward pressure on prices," he added. According to the research the bloated inventory-to-sales ratio, high foreclosure rates, and inertia in housing markets imply that recent price declines are likely to continue.

The research also considered whether the current fall in U.S. housing prices represented a nationwide bust. "While the national price level is falling on every measure, there is an opinion that this decline might reflect oversized drops in a few isolated markets rather than a countrywide phenomenon," it said.

Ilargi: What makes me doubt the IMF paper even more is a graph like this, which CalculatedRisk posted yesterday. If sales just keep falling, and inventory still rises at this point, there is simply no turnaround in the US housing markets anywhere in sight.

Fitch Ratings, arguably the only rater with their act together other than Egan-Jones, just finished with its ResiLogic enhancements. Its new mortgage loss model will be released today. In it, its new National, State and MSA-level economic and house price forecasting will make their modeling ‘far more predictive and forward-looking.’ That is a nice way to put it.

BIG PROBLEM - This more micro look at the housing market in the 25 MSA’s that in the past have contained the most ‘non-conforming (Jumbo) lending, is coming up with massive house price losses in key areas with San Diego dropping as much as 47% over the next 5-years! San Francisco is looking at an additional 33%.

These are your heavy Alt-A areas. Fitch is getting ahead of the curve this time around. I have been telling you for a few months now that according to my proprietary data while subprime defaults are falling slightly, Alt-A defaults have been soaring in the past four months led by Pay Option ARMs. Prime defaults have also spiked.

Their estimates are dire, but I feel could still be on the conservative side given the absolute lack of non-conforming financing, massive supply, sales not picking up substantially this summer selling season, over 40% of all sales coming from the foreclosure stock, values only falling for about a year and defaults in Alt-A and Prime mortgages substantially picking up steam.

The MSAs represent the 25 areas that have historically exhibited the most non conforming mortgage lending activity. ‘Some MSAs such as San Diego and San Francisco, CA are expected to experience home price declines by as much as 47% and 33% over the next five years, while home prices in MSAs such as San Antonio, TX are expected to appreciate by 7%, over five years,’ said Somerville. The home price forecasts are imbedded in the state and MSA level risk indicators and will be updated quarterly.

ResiLogic’s new model looks to be robust and takes into consideration many of the things that are top on my list of risks. The systems new capabilities include:

Introduction of MSA and national macroeconomic risk multipliers;

Ability to analyze seasoned loans and to take into account loan payment history and house price changes since loan origination;

Additional penalties for loans originated with stated income or no income/no asset documentation programs;

Additional penalties for loans originated with second liens;

Reduced credit for loans with mortgage insurance

This new model will negatively impact Fitch’s loss assumptions and credit enhancement levels for Residential Mortgage Backed Securities. This is mostly your Prime and Alt-A RMBS and not the subprime, meaning if S&P and Moody’s update their systems, round 2 of the mortgage and housing implosion could kick off with Alt-A and Prime leading the way.

Ilargi: Bill Poole was CEO of the St. Louis Fed for a decade, and left earlier this year. He says a lot of right things in this NYT op-ed, but one thing is missing. Now, I haven’t followed the Fed board meetings word for word over the past ten years, but something tells me that if Poole would have spoken out for the policy changes he mentions here, we would have seen his words reprinted by now. In other words: Bill, if you knew 10 years ago, why didn’t you say so? Why do that when it’s too late?

Critics of the Congressional housing package complain that we are now committing taxpayers to huge new outlays to rescue Fannie Mae and Freddie Mac. That view is wrong: Congressional inaction over the past 15 years had already committed taxpayers to the bailout.

Congress could and should have required Fannie and Freddie — which enjoy a peculiar and highly advantageous status as quasi-public agencies and quasi-private companies — to maintain more capital, but didn’t. Now the costs from Congressional inaction are becoming painfully apparent, and they cannot be avoided. To permit the two mortgage giants to default would set off a worldwide crisis.

But we can decide what should become of Freddie and Fannie after this crisis. The best option is one getting little mention in Washington: get rid of them. Because the government cannot permit Fannie and Freddie to default, their obligations are part and parcel of the full-faith-and-credit obligations of the United States. Thus, the national debt, usually viewed as the $5 trillion held by the public, is really $10 trillion once we add the Fannie and Freddie obligations and the mortgage-backed securities they guarantee.

For now, the Congressional Budget Office has entered a “place holder” of $25 billion to cover the bailout costs over the next two years but recognizes that this is a guess. The important issue is not the 2009 outlay, but the total that will be required eventually. Even if the two firms are technically insolvent, the market will continue to buy their obligations readily, for it understands that they are fully backed by the government.

Given this faith on the part of the marketplace, there will be no immediate catastrophe that would force the federal government to provide additional capital to Fannie and Freddie. The situation is similar to the one in the 1980s, when many savings and loans were technically insolvent yet had no difficulty attracting deposits, as they were covered by federal deposit insurance.

So the federal government has the option of delaying any ultimate resolution of the Fannie-Freddie mess, as it did with the savings and loans 20 years ago, in hopes that the two giants can dig themselves out of the hole. Still, it seems more likely that — again, just as in the 1980s — the longer we delay, the higher the eventual taxpayer cost will be.

Freddie Mac, according to its own fair-value accounts for the end of March, is technically insolvent — the estimated market value of its liabilities is greater than the estimated market value of its assets. Fannie Mae has a small positive net worth. In coming quarters, these figures may deteriorate because of accounting adjustments (some of the assets are questionable) and continuing defaults on mortgages. The eventual losses could run to several hundred billion dollars.

Whatever the amount of the bailout, even if “only” $25 billion, the real question is not immediate survival of the loan giants but their long-term future. Instead of being regarded as too big to fail, we should look at them as too big to liquidate quickly.Fannie Mae and Freddie Mac are not essential to the mortgage market; if they were put out of business in an orderly fashion over 5 to 10 years, the market would pick up the business they abandon.

Fannie and Freddie exist to provide guarantees for mortgage-backed securities trading in the market. The business is simply insurance. There are lots of insurance businesses around: property, auto, life and many others. These markets work fine without any government-sponsored enterprises. They are not highly concentrated into a small number of dominant players whose failure would threaten the entire economy; rather, lots of companies compete and spread the risk.

Indeed, there are well-established firms in mortgage insurance, but their growth has been stunted by the special advantages Fannie and Freddie enjoy. In fact, there has already been a test case for how the mortgage market would function without Fannie and Freddie.

After an accounting scandal in 2005, regulators severely constrained their activities. The nation’s total residential mortgage debt outstanding rose by $1.176 trillion in that year, even though Fannie’s and Freddie’s stakes rose by only $169 billion, just 14.4 percent of the total. In essence, the market barely noticed that the two agencies’ private competitors were providing 85 percent of the increase in mortgage debt in 2005.

There are more general economic reasons for liquidating Fannie and Freddie, the biggest being that it is very dangerous to maintain such a large role in any market for only two operators. Markets work best when numerous firms compete against each other. And then there is moral hazard. Knowing they had a federal backstop, Fannie and Freddie held too little capital and the market financed their activities at interest rates very close to those enjoyed by the government.

Now we are living through the result. Does it make sense to reconstitute them so that they can engage in a repeat performance? Some believe that tighter regulation is the answer. I am skeptical of that because I know the extent to which the regulatory system is tied up in Fannie’s and Freddie’s political activities.

I find it deeply troubling that Fannie and Freddie, essentially in receivership to the secretary of the Treasury today, continue to employ lobbyists and hand out campaign contributions to influence the legislative debate over their own futures. Fannie and Freddie paid out more than $170 million to lobbyists over the last decade — more than General Electric spent.

Government departments cannot hire lobbyists or give money to campaigns — why should Fannie and Freddie, now wards of the government, be permitted to do so? The long-term health of the mortgage market is too important to be left to only two firms.

If Fannie Mae and Freddie Mac can survive as vigorous competitors without the special government privileges they’ve long enjoyed, fine. But if they insist on coming back to life as public-private hybrids with all sorts of unfair federal advantages, we’ll only be setting ourselves up for more disasters. The wisest move, in the end, is to carefully let them wither away.

William Poole, a fellow at the Cato Institute, was the chief executive of the Federal Reserve Bank of St. Louis from 1998 to 2008.

"The affirmation of the senior unsecured debt ratings reflects the strong explicit and implicit support these government-sponsored enterprise (GSE) securities hold in the marketplace," said Standard & Poor's credit analyst Victoria Wagner.

The most recent public demonstrations of government support by the U.S. Treasury underscore the key public policy role and the key liquidity role the congressional chartered GSEs have in the U.S. mortgage markets. This is reflected in the current stable outlook on the senior unsecured debt.

The U.S. Treasury's three-point liquidity back-stop plan has been added to the pending Housing Reform Bill, HR 3221, which passed a vote in the House on July 23, and is now under review for a vote by the Senate.

The weak mortgage credit cycle driving credit losses higher at Fannie Mae and Freddie Mac has led to a crisis of confidence in the strength of their capital positions as the GSEs are facing higher demands for liquidity while their own core mortgage performance is weaker, and there is a higher degree of uncertainty regarding the broader market conditions.

This is reflected in the weak pricing of their equity shares during the past few weeks. The broader financial markets remain quite stressed due to the severity and duration of this weak housing and mortgage cycle. Because of this, it looks like HR 3221 will be signed into law within days.

Although there is still ambiguity on the part of regulatory authority as it applies to how nonsenior creditors of Fannie Mae and Freddie Mac would be treated if the U.S. Treasury ever acted on its three-point liquidity plan, the language in HR 3221 increases the likelihood that subordinated debtholders and preferred stockholders would face greater subordination risk.

This heightened risk is not incorporated in our current subordinated debt and preferred stock ratings on Fannie Mae and Freddie Mac. We may lower these issue ratings one to two notches at the conclusion of our review of the final legislation. Prior to this we had not incorporated traditional notching of Fannie Mae and Freddie Mac's subordinated debt and preferred stock in relationship to the risk-to-the-government ratings.

This is now under consideration, notching the subordinated debt and preferred stock ratings one notch below the risk-to-the-government ratings. Both firms face weak earnings due to rising credit expenses. The CreditWatch listing on the subordinated debt, preferred stock, and risk-to-the-government ratings underscores the expected higher stress on capital and earnings these firms face during the next several quarters.

The confidence crisis in the equity markets is adding to the already stressed business cycle and creates additional challenges in the near term for capital-raising initiatives. In addition to a detailed review of the final version of the Housing Reform Bill, we will reassess our view of the respective firms' earnings, credit performance, and capital adequacy levels.

Currently, both firms operate with a solid capital position above the regulatory minimum capital requirements, but with a lower capital cushion above the regulatory surplus requirement. Fannie Mae raised $7.4 billion of new equity in the second quarter to further bolster its surplus capital position. Freddie Mac's regulatory surplus capital position is currently lower, and it has committed to raise $5.5 billion of capital in the near term.

If we believe that operating losses reach a level that significantly reduces the surplus capital position and further threatens capital-raising efforts to support the respective businesses, we could lower the subordinated debt and preferred stock ratings by one to two notches. The risk-to-the-government ratings on the respective firms could either be affirmed or lowered one notch

Secretary Paulson claims that if he has "a bazooka in his pocket" that he won't have to draw it. Uh huh. Come again Hank?

If you show up to a fight with your bare fists, the other guy is likely to actually fight you. If you draw a knife, he'll stand back 30' and shoot you with a gun. And if you have a Bazooka, he'll cold-cock you from behind because he knows if you get to draw it you'll blow him to Hell.

This, in fact, is the dumbest thing that Congress could have done. So why did they? I'll hazard a guess, and let me point out that this is all that it is. "Someone", perhaps Bill Gross of PIMCO or some "foreign interests", told Paulson (or Bush, or both) that if they didn't backstop their "investment" in this GSE paper that they'd dump their Treasury holdings, and screw the bond market.

But can Paulson actually backstop the GSEs? No. And here's why. See, the government can never really "fix" the economy. Government, of course, gets all its money from the economy. Therefore, whenever the government does something like this it can only rearrange where the money comes from and goes to - it can't actually add to the outcome.

Let's say there is $100 in value in the economy, for the sake of argument. Government can "decide" who gets $75 of that $100, but what it can't do is make the $100 grow to $200, because the entirety of its money comes from the $100. Some will say "but they'll just print more money!" to which I reply, "that's nice; you now have $200 but the value of each of those dollars has been cut in half!"

So in reality, Government can't backstop the GSEs, because government can't make bad paper good, nor can it create more value. It can rearrange who gets screwed, but not whether the screwing is going to happen in the first place.

There is a mass delusion foisted off on The American People that The Fed, or Government generally, can prevent recessions. This is false; The Government, again, gets all of its money from the economy. Since it has no exogenous (outside) means of acquiring wealth to spend, it cannot change the actual outcome.

What it can (and does) do is distort the outcome. For instance, Government can (and did) stop the decline in the market after the 9/11 attacks, preventing the full realization of the .COM bubble explosion from occurring. But in doing so it blew an even bigger bubble in real estate, and now, we're out of places you can find a bigger bubble to blow!

Since Government is (like all things) inefficient, to "rescue" one popped bubble you need to be able to blow a bigger one. There are no bigger ones available to blow.

Government, folks, causes Depressions. It does so by gimmicking what are ordinary slowdowns in the economy and turning them into catastrophes. The really bad ones tend to happen once all the people who went through the last one are dead, because those who were adults and went through the last one remember how badly it sucked, and they won't let it happen again.

We've enjoyed 80 years of relative prosperity. We took bad choices in the 1970s, and paid with a nasty recession and stagflation into the early 80s. We too bad choices in the 1990s, and paid with the 2000 tech market collapse. We took bad choices from 2003-2007, and now are starting to pay for them in 2008.

This is not over, and this bill will not "fix it". It will in fact make it much worse, because once the market realizes that despite spending $1.3 trillion dollars (the total blown thus far) that has not managed to stop the bleeding the bond and equity markets will suddenly "get it." Don't be long equities when it happens.

Do not be in debt, period. Do not have more than $100,000 in any bank. ANY bank. Pray for our nation, if you're the praying sort.....

We all know by now that the U.S. banking sector is badly broken. The real question is what to do about it. I think a few core principles need to be followed when devising a plan for healing the banking sector: 1. The plight of equity-holders should be ignored; 2. Long-standing rules governing bank ownership shouldn't be compromised in a panic; and 3. Bank balance sheets won't heal unless deep pain is felt, and preferably as quickly as possible.

Bank Equity Holders: Out of Luck Investors in junior securities, be they common shares, preferred stocks or subordinated debt, enjoy premium returns in the good times and bear disproportionate risks in the bad. They should not have a seat at the table in a bail-out scenario. When considering the plans put forth for rescuing the GSEs - Fannie Mae and Freddie Mac - I do not want to see Treasury Secretary Paulson spending my tax dollars propping up existing equity holders.

This is money that should go to restoring liquidity and order to the mortgage market and enabling debt holders to get their money back. Equity holders - they should be wiped out. GSE equity holders have long enjoyed the benefit of a guarantee off the backs of the U.S. taxpayer; now the tables are turned and it's payback time. If you want the potential returns to equity, then you need to shoulder the risks to equity. And those risks have been borne out. And you are busted.

Now, this is an issue separate from fraud. If it turns out the disclosures were improper and that equity holders did not have the information necessary to make an informed investment decision, then by all means file a class-action lawsuit and seek appropriate remedies. But this is also part and parcel of being an equity holder. Bad things can and do happen. It's high time that equity investors understood this. And I'm not the only one to have this view: consider the words of David Einhorn, manager of the widely-respected hedge fund Greenlight Capital, from his book Fooling Some of the People All of the Time:

The truth is that investors in corporate securities are risk takers managing investments of risk capital. One risk is fraud. The best way to discourage fraud is to actually enforce the penalties for fraud. If investors believe that companies making false and misleading statements will be punished, they will be more sensitive to what is said. And, because their money is at stake, investors will allocate their capital more carefully.

Exactly.

Don't Play Games With the BHCA The thought that bank ownership rules should be relaxed because of the need to attract liquidity into the sector is deeply misguided. While there are plenty of rules and regulations with which I disagree, but the long-standing Bank Holding Company Act rules make a lot of sense to me.

Banks play a special role in the fabric of our economy, from money creation and credit to safety and access to liquidity. These are not areas to be trifled with. Further, I think proposed rule changes really cloud the issue. If the sector needs more capital, then the question needs to be asked; what can be done within the existing rules and regulations?

We have the example of TPG/WaMu, which, I'm afraid, is not a template for bringing capital into the sector. This was a deal done behind closed doors, at terms that frankly illustrate why the sector is so badly damaged. TPG wanted lots of cushion in order to do a deal, because of a high degree of uncertainty surrounding the investment portfolio. It presumably took large deal fees.

The structure was also massively dilutive to current shareholders, and further provided anti-dilution protection against subsequent capital raises at prices lower than its deal price for 18 months. I'd be willing to wager that this is one anti-dilution feature that will surely end up in-the-money. Not bad, TPG. But to be fair, if I was TPG I'd have pushed for the same deal. Why? Because almost every large financial institution in the U.S. is made up of two institutions; a good bank and a bad bank.

Good Bank/Bad Bank as a Way to Move Forward The good bank is a bank we can understand, analyze and readily price. The bad bank, well, is bad for a reason. It contains a large number of very complex, hard-to-value instruments. Mortgages. Illiquid derivatives. Leveraged loans and loan commitments. So an investor in such a combined good bank/bad bank entity is likely to pay a sharply discounted value for the good bank because the bad bank is so bad, or at least it's potential losses are so unclear.

What I believe we really need is a good bank/bad bank approach to the current banking sector woes, causing all banks to shrink by offloading their bad bank instruments into either a bank-specific vehicle (like Citi taking its bad assets and selling them into a "Citi Bad Bank") or a series of pools organized by asset type (similar to the Super SIV idea, except separate vehicles for mortgages, derivatives, leveraged loans and unfunded commitments).

The instruments to be marked-to-market upon transfer and funded by private capital, which will now demand a return in line with the risk without placing unnecessary downward pressure on the valuation of the good banks that remain. And if private capital wishes to fund the good banks who now have clean balance sheets and are ready to expand but are short on capital, they will receive a return commensurate with healthy, good bank growth capital.

This approach does not require a change to the Bank Holding Company Act, but it does require bank managements to take big hits to equity - now - in order to lay a strong foundation for future growth.

Note to Bank Managements: Take the Medicine - Now Bank management's steps towards fixing their balance sheets has been a slow, painful process, which is likely to be played out over even longer periods of time. This, in my opinion, is a huge mistake. It is both costly to their firms and for the economy, as the pervasive lack of confidence in our financial institutions will remain until the problems are cleaned up.

But healing can only happen if investors have greater transparency into the future of these firms, which means really understanding the risks embedded in their asset books. And as it stands today, there are still way too many unknowns to make financial commitments to the sector. Those who did so early got smoked, and others, like TPG, received deals that ultimately hurt the bank and its shareholders and don't address the issues of transparency.

Mr. Paulson should devote more calories to this issue and less to bailing out the GSE's and protecting their common stockholders. Yes, the GSEs are hugely important, don't get me wrong. But the larger banking sector needs fixing, and it appears that a little prodding is in order.

Without the health of our banking sector, I do not see a foundation for recovery. The Treasury, the Federal Reserve and bank managements need to wake up. An incremental approach to rebuilding financial strength, trust and confidence is a fool's game. Get to it.

Long time readers are familiar with my fascination with antique sports cars. One of my pals, Jan, is a well known Porsche collector who is also affiliated with the International Automotive Appraisers Association (IAAA). Its a hobby for him, and he specializes in the rehabilitation and appraisal of antique sports cars. He has rebuilt and appraised everything from celebrity Bugattis to classic Ferraris to modern supercars.

I call Jan "landed gentry" -- he's owned a major car rental firm (sold it), develops real estate, buys/sells land and houses. He is quasi-retired, leaving him plenty of time to play with his many fine automobiles -- and for us to discuss the housing market collapse.

Amongst our many discussions, we have gone over the issue of housing appraisal fraud. So when the IAAA newsletter sent out the tale (below) to its members as a warning against fraud, conflict of interest, and corruption, it got his attention -- and he forwarded it to me. His comments were: "This is even worse than the nightmare of corruption you described."

Let me hasten to add that many appraisers were offended by the corruption of colleagues in their industry, especially those greased by the worst elements among mortgage brokers and real estate agents. In 2005, more than 8,000 appraisers -- roughly 10 percent of the industry -- signed a petition asking the federal government to take action; the White House and Federal agencies demurred, and appraisal fraud continued unabated.

Eventually, Phony and Fraudy cut a deal with NYS AG Cuomo to stop enabling the appraisal fraud. Which brings us to the now defunct Indy Mac, and the below diatribe about the criminality, corruption, and rampant appraisal fraud that was the CountryWide spinoff's stock in trade. The original piece was published by Vernon Martin at the Appraiser's Forum (http://appraisersforum.com). His story is utterly fascinating, and it deserves wider distribution.

Martin was the chief commercial appraiser for Indy Mac from October 15, 2001, to when he was terminated six months later for failing to look the other way or actively engage in fraud. Most of the details below are culled from the public record of his wrongful termination litigation, which was eventually settled in Martin's favor. My quick overview of the conflicts, fraud, and criminality at Indy Mac --

Fraud:

Underwriting loans based on appraised values well above purchase prices;

Fabricating rent rolls for commercial properties to be appraised;

Over-stating Construction work as 80% complete versus 15% in actuality;

Attempting to change discounted cash flow models for subdivisions in order to increase appraised value;

Criminality:

Attempted intimidation of Appraisers;

Providing false information to appraisers;

Conflict of interests:

Appraising a development where the land was being purchasing from David Loeb, IndyMac’s Chairman of the Board;

On one transaction, the CEO's father and father-in-law were commercial construction inspectors for the firm; the loan officer was the CEO's brother (a former police officer with no loan experience);

That's just the overview.

Amazingly, these events took place before the enormous Housing and Construction boom from 2003-06. One is left to imagine just how insane the place must have been during that period. I'd love to find the details, and given the enormous lending losses -- $8B and counting -- we can only begin to imagine what sort of rampant fraud took place. I hope the FDIC releases a full report of their investigation of the collapse of Indy Mac.

You really need to read the entire piece to get a feel as to just how much of a criminal enterprise Indy Mac was before it went under.Is it any surprise the entire firm, and not just any individuals, are under FBI investigation for Fraud?

I’ve been writing a bit over the last few months about the financial mess we’re about to fall into and an event I’ve been expecting for a while came to pass late last week – a foreign bank wrote down all of their U.S. CDOs to $0.10 on the dollar.

This event, the long dreaded "mark to market" for CDOs, has implications for all bonds, both commercial and municipal, due to the exposure monoline bond insurers have. This matters for stocks as commercial bonds are often the offerings of publicly traded companies, it matters for the pensions that will have to fire sale all bonds that stop having a AAA rating if the monoline insurers implode.

It’s happening against the backdrop of the first of what promise to be somewhere between 900 and 2,200 bank failures that will result in an FDIC bailout to match the recent Fannie Mae/Freddie Mac bailout. Grab a bottle of scotch and your teddy bear, ‘cause you’re gonna need both before this is done.

A CDO is a collateralized debt obligation. All those ‘for sale’ signs on your street? The mortgages of those foreclosed houses are part of a CDO somewhere. The repossessed car that belonged to the people that lived there? That loan was part of a CDO. The credit cards they defaulted on? Part of a CDO. Starting to see how this works?

A CDO has a credit rating – the underlying issuing entity pays a monoline insurer an insurance premium for which they receive a "AAA" or investment grade rating on the instrument. The monoline insurers used to be the most boring sort of business in the world, taking a little slice of each bond issue and loaning out their AAA rating in exchange.

The risks were well known, they scored consistent, unexciting profits, and life was good. They got seduced by the dark side, began insuring make believe financial instruments, are now on the hook for CDO performance, and now the two in New York, AMBAC and MBIA, are under intense scrutiny from the New York insurance commission and will certainly fail.

This stuff is all like a pile of discarded California Christmas trees on February 1st. One little spark and the whole business will go whoooosh in a puff of flame. Bank of America purchasing Countrywide? Totally and completely about not having to fess up to what their mortgage bundles were worth; it would have taken down both companies and the rest of our economy along with it. J.P. Morgan buying Bear Stearns? More concealment in action with the hand of the U.S. Treasury guiding the event.

Pension plans have rules – they can’t own crap. They own a lot of CDOs which are crap in their own right and they also own lots of other bonds which will become crap due to the loss of their AAA rating when a run on the monoline insurers begins. They'll have to sell, sell quickly, and that means prices for all of these sorts of securities will tumble.

The triggering event for the run on the monoline bond insurers could not come from within the United States; the Federal Reserve, the U.S. Treasury, the Congress, and the White House have all shown a willingness to do whatever was necessary to head off this day of reckoning. It was always obvious the trigger for the meltdown would come from a "mark to market" occurring outside the control of these entities.

National Australia Bank’s decision to value the CDOs it holds at 10% of their face value (this is what got me started on this diary) may very well be the event that will trigger the destruction of the monoline insurers, the revaluing of CDOs from their "mark to model" to "mark to market". If you prefer to be more direct you can call it "mark to meltdown".

These synthetic securities or derivatives (Just call ‘em funny money) were valued via computer models that purported to express the percentage of debtors who’d fail to pay. No one actually sold these things in the open market, they just bought and held them, taking the payments that came and trusting the investment banks that were bundling up and selling these.

At the moment, 8,400 more families go into foreclosure every day in the States. It is estimated that for each one of those foreclosures, neighbourhood property values fall 1% in a single day. Last year 1,500,000 families lost their homes, and mortgage defaults caused panic in global financial markets.

To stem the collapse, lawmakers have raised the debt ceiling of the US by $800 billion, and are on the verge of approving homeowner relief that could cost $100 billion. Fears are, however, it will have little effect.In Canada, the average price of a house in both Edmonton and Calgary has declined by over $42,000. Home sales are down 43% in Vancouver.

And a guy in PEI tells us the cottage he sold for $89,000 last summer is now on the market for $45,000. In one of the wealthiest enclaves of Toronto, the Kingsway, a home listed at $1.9 million found no buyers, even at $1.7 million, and then at $1.5 million, before the owners gave up.

In Woodbridge, local realtors say there are properties which have been shown more than a hundred times, yet no offers. A year ago, they’d have fetched more than the asking price.

This week the chief economist of the Export Development Corporation said these are “dark times” for our exporters. “I’m not one to paint a rosy picture at all,” added Peter Hall. He thinks exports of consumer goods will crash this year by 18%, and more next year, the victim of rising commodity prices, the US financial and housing crisis, and the high Canadian dollar.

The Bank of Canada’s now forecasting inflation of something more than 4%, after the dramatic increase announced this week. Gasoline costs have jumped over 26%, and food prices are up by a third. It means interest rates will likely be increasing soon, jacking mortgage payments, just around the time the federal government ban on 40-year amortizations and zero-down home payments deflates the housing market. By the way, CIBC raised mortgages rates on Thursday.

I could go on. As few as 90 and as many as 300 US banks are expected to fail this year. One, perhaps, two major car companies could declare bankruptcy. The Fannie Mae and Freddie Mac bailout may not work, causing the mother of all budget problems in Washington, just as the Presidential election unfolds.

As the Canadian exporting numbers and the job losses in Oakville show, our economy is being dramatically affected by these realities. There are families wondering tonight what the hell they’re going to do now after that third shift failed. There are more than 60,000 families across Canada trying to sell their houses. There are companies quietly failing each hour.

As I drove through a number of southern Ontario cities in recent days, my eye could not help but see empty stores on main street and vacant units in the industrial park. Sadly, the market declines I foresaw nine months ago when I wrote my latest book are starting to occur. The depths are yet to be known.

My earlier forecast of a general 15% drop in the national average sale price may end up being too optimistic. In any case, billions in net worth are about to evaporate, just as the stock market bears come out, energy prices soar, Ottawa falls into deficit and interest rates rise.

The perfect storm. In coming days, I will review some of the shelters from it.

The Treasury is preparing a radical rescue plan for the housing market which may involve pumping billions of pounds into the stricken mortgage markets.

Alistair Darling, the Chancellor, has asked his leading advisers to investigate a plan to provide government support for lenders until the financial crisis has abated. The proposal is being investigated ahead of the completion of Sir James Crosby's report into the funding struggles faced by UK banks.

Crosby, the former HBOS chief executive, will present his interim report to the Treasury on Tuesday, and is expected to warn that banks are facing a massive "funding gap" caused by the collapse of the securitisation markets which previously provided around 40 per cent of backing for home loans. Experts think the gap to be filled by the Treasury could amount to £40bn-£50bn a year.

Sir James will warn that the mortgage famine, which is pushing prices up significantly for both buyers and homeowners who are renewing their deals, could persist for years, with painful consequences for the housing market. Although he will not provide cast-iron recommendations until his final report in October, he is expected to warn the Government that some form of intervention is necessary to lessen the eventual economic pain.

In advance of his recommendations, Treasury officials have been working hard to formulate a rescue plan based on his interim findings. Under this plan, the Government would offer to swap new mortgage debt with banks for gilt-edged government securities.

The scheme is very similar to the Bank of England's Special Liquidity Scheme in which the Bank swaps treasury bills for old mortgage debt, except in this case the scheme would cover new mortgages issued this year. It remains unclear as to what role the Bank would play in the new scheme, although Governor Mervyn King is thought to be reluctant to have a direct role in what many would regard as a bail-out for the UK mortgage market.

In reality, the scheme would be designed to support the wider housing market and economy. According to Peter Spencer, economic adviser to the Ernst & Young Item Club, the faster the Government acts, the less it will ultimately have to spend supporting the economy.

"I would be opening my cheque book to the banks and building societies to try to stop the [housing market] slide," he said. "If there are people out there prepared to borrow money from the Government through banks and building societies then that's what we need at the moment.

The sooner the Government spends the money the less it will have to spend eventually. Once these markets collapse and confidence disappears, there are all sorts of consequences in terms of job losses, which will be even more costly for the wider economy."

In 2006 total net mortgage lending amounted to just over £100bn, with around £60bn of that funded by banks' deposits and the remaining £40bn by securitisation. The demise of the securitisation markets, in which banks package and sell on the mortgages to investors, left lenders with a £40bn hole if they intend to lend as much as previously.

They are also having to pay back investors of the existing mortgage backed securities around £20bn a year, so the hole is as large as £60bn. Experts warned that although the nationalisation of Northern Rock and subsequently the special liquidity scheme helped support the market temporarily, this effect is now wearing off.

Many analysts have warned that the number of new mortgages being issued could drop to almost zero by the end of the year. The British Bankers' Association reported this week that the number of mortgages approved for home purchase dropped by more than two thirds in the year to June, hitting just over 21,000 last month.

Although the Government is highly wary of being seen as risking taxpayers' money on a rescue operation of the mortgage market, there are precedents for providing such support. The Labour Government of 1974 did so with a £500m loan, and the current crisis is regarded as far more pressing.

It will also ensure that the loans are only accepted with a major "haircut" and on such terms that they will only be at risk if house prices plunge by unprecedented and entirely unanticipated rates. It can also point to actions being taken by the US administration to shore up its own housing market.

As well as taking radical action to support Fannie Mae and Freddie Mac, which support its domestic mortgage market, Congress yesterday passed a major package of housing legislation including tax relief for homeowners, a new regulator for Fannie Mae and Freddie Mac, and a $300bn anti-foreclosure programme.

Another plan being considered by the Treasury is to multiply the amount of cash it is providing to local authorities to buy up homes from developers.

Ilargi: The presence of National Bank Australia, which made waves when it wrote down its US conduit loans a few days ago, in the take-over talks in Britain, might reverberate through the system. Some parties involved will ask why they did their write downs.

With bid speculation intensifying after its failed rights issue, the high street mortgage lender is among a raft of banks reporting this week.

HBOS, the mortgage lender at the centre of bid speculation following its spectacular rights issue flop, is expected to add to the gloom surrounding its brand this week by disclosing that its first-half profits are 60 per cent lower than last year.

Andy Hornby, chief executive of HBOS, will report its interim results on Thursday. Other banks also reporting include Lloyds TSB, Alliance & Leicester (A&L) and Allied Irish, in a bellwether week for the troubled UK banking sector.

In the past week, HBOS has been at the centre of market speculation that Spain's second-largest bank, BBVA, is considering making a bid. The British bank's £4bn cash call flopped nine days ago after just 8.3 per cent of shareholders took up their rights. This left underwriters Morgan Stanley and Dresdner Kleinwort with a £3.8bn "rump" of shares, representing just under 6 per cent of the company.

The bid speculation intensified on Friday after it emerged that JPMorgan, the US investment bank, had held talks with several interested parties about breaking up HBOS. JPMorgan was reported to have spoken to National Australia Bank (NAB) about buying HBOS's Australian division, BankWest, and its corporate banking arm.

The investment bank is also claimed to have spoken to the Spanish banking giant Santander – which a fortnight ago agreed to take over A&L – and private equity firms. However, that rumour was widely dismissed by sources close to the institutions said to be involved in the talks.

The speculation was further dampened on Friday, after NAB wrote down an additional A$830m (£400m) from its investments in US housing mortgages, and analysts raised concerns about another A$4.5bn the bank holds in loan assets. "We're not sure this is a clever time to make acquisitions," NAB's chief executive, John Stewart, said, shortly after announcing the writedowns.

Investors initially seemed opposed to the prospect of a break-up of HBOS, with shares down 3 per cent in early trading before closing up 2.9 per cent at 310p, above the rights price of 275p. Banking analysts Mark Phin and James Hutson at Keefe, Bruyette & Woods (KBW), expect it to reveal pre-tax profits of £1.16bn – a 61 per cent drop on the same time last year – after it absorbs £1.02bn of Treasury losses.

Alex Potter, banking analyst at Collins Stewart, said he believed HBOS was now discounting too much bad news: "Earnings will be far less closely watched than movements on writedowns, as well as management's willingness to engage in self-help," Overall, he expected the so-called banking results season to be characterised by a "myopic obsession with the balance sheet and capital ratios".

Lloyds TSB, which will report on Wednesday, is expected to outperform its peers thanks to its relatively low-risk strategy. Allied Irish, expected to have single-digit earnings growth, will also report on Wednesday. A&L, which KBW expects to have a modest pre-tax profit of £5m, will report on Friday.

The City watchdog surprised the market on Friday, June 13, by announcing a dramatic clampdown on short selling during rights issues.

For some in the City, this rapidly became known as the Dennis Stevenson rule, after the politically well-connected chairman of HBOS, Britain's biggest mortgage lender whose share price was in the middle of a particularly nasty stock market storm.

HBOS - whose crown as the UK’s market leader is expected to be stolen by Santander-owned Abbey this week - had announced a £4bn rights issue in April, but was being battered by speculation ranging from fears of a black hole in its corporate banking business to jitters about further write-offs from investments in US sub-prime mortgages.

Overriding everything was speculation that the outlook for the largest home loans institution in the UK was getting far worse, and that it would struggle to raise funding for its huge mortgage book in the wholesale money markets at profitable rates.

Lord Stevenson, who has been chairman of HBOS for nine years and also holds a string of other positions, including that of chairman of the House of Lords appointments commission, took action. He lobbied the Financial Services Authority about trying to restore calm.

The best bet, he said, would be to force short sellers - who sell shares before they buy them in the hope of benefiting from a fall in the price - to disclose their positions. Sir Derek Higgs, chairman of Alliance & Leicester, who died suddenly in April, had raised a similar prospect with the FSA, but was turned down.

This time, the FSA agreed, announcing without warning that anyone with a short position worth 0.25 per cent of a company during a rights issue period would have to disclose it. For some of the bankers and advisers that have been trying to steer the UK's banks through the extreme conditions of the past year, this was the clearest sign yet that the FSA had serious concerns over the sector's stability.

Any risk to HBOS's rights issue might be the final straw, which would push weak players, such as Bradford & Bingley, and strong ones - including Barclays, Royal Bank of Scotland and Lloyds TSB - into a tailspin. People close to HBOS have played down the idea that there was any panic about its capital raising, which was fully underwritten by the investment banks Morgan Stanley and Dresdner Kleinwort.

The insurance policy paid off. Despite a low take-up by investors of the new shares, HBOS got its money this week, with Morgan Stanley and Dresdner soaking up a large chunk of the issue. Andy Hornby, the bank's chief executive, will have little time to breathe a sigh of relief.

On Thursday he unveils HBOS's half-year results, and they are expected to be grim, showing both an increase in problem mortgages and credit cards and rising impairments in HBOS's corporate bank, where almost half of the loan book is advanced to the commercial property, housebuilding and retail sectors.

James Eden, an analyst at Exane BNP Paribas, said: "The HBOS model has been extremely severely challenged. Significantly higher funding costs have rendered some types of asset growth unprofitable - mortgages in particular." Leigh Goodwin, at Fox-Pitt Kelton, said: "HBOS faces a perfect storm. We think profits will fall for the next three years."

The downbeat outlook for HBOS has led to speculation that the business, which a year and a half ago was seen as one of Europe's most dynamic players, cannot survive on its own. Yet the slump in the share price of most UK banks means HBOS is not alone in facing a threat of a takeover by one of the few global financial institutions that have emerged largely unscathed from the meltdown caused by US sub-prime mortgages.

However, RBS, Barclays and even Lloyds TSB would be harder to take over than HBOS owing to their size and complexity. Yet, at the same time, HBOS would still provide a sizeable entry into the UK market.

James Chappell, a banks analyst at Goldman Sachs, made HBOS a "conviction buy" this week, because its shares are trading at a discount to tangible book value - the notional sum that investors might receive if the company is broken up and sold off. HBOS's shares are on a multiple of just five times future earnings. "These are all below the lows seen during the last recession in the UK in the early 1990s," Chappell noted.

HBOS's low share price has prompted speculation it will be snapped up. In the past week there were rumours that BBVA, Spain's number two bank, was interested. JP Morgan, the US investment bank fresh from its audacious takeover of Bear Stearns in March, is understood to have held exploratory talks about forming a consortium to mount a break-up bid for HBOS.

Among those contacted were National Australia Bank, run by John Stewart, the former Woolwich chief executive. NAB, which owns Clydesdale and Yorkshire banks in the UK, has historically showed interested in both HBOS's Australian business and the corporate banking business in Bank of Scotland.

A major hurdle for any acquirer of HBOS is the size of its balance sheet. While its market capitalisation, which is £15bn after its rights issue, might not be too much for some of the larger banks to swallow, its balance sheet, at £670bn, is one of the largest in the world.

However, the size of its balance sheet, and its pressing funding requirements, are also one of the major reasons why HBOS could be a takeover target. To fund its mortgage book, which accounts for £235bn of its total £430bn loan book, HBOS has to renew about a third of its funding every year.

HBOS has admitted its profits margins will be significantly squeezed, owing to the higher price it must pay in the money markets. Yet HBOS's assets are mortgages. It claims these are highly transparent and are still seen as among the safest assets by many including the Government, which accepts only triple-A rated mortgage backed securities as collateral for loans from its special liquidity scheme.

Some believe the biggest source of worry over HBOS is not funding, but potential further writedowns on its £40bn book of investments in structured credit such as US mortgages. Sandy Chen, of Panmure Gordon, said that having to crystalise losses on this book would be a "poison pill" for any buyer of HBOS.

Amid this gloom, Hornby, 40, will next month mark his two-year anniversary as chief executive of HBOS.Either way, all bets on the fate of the bank and its chief executive could be off if, as is increasingly expected, the Treasury decides to extend its special liquidity scheme and provide extra support for the mortgage market.

Ilargi: Just one more example of how the credit disappearing act will hit absolutely everywhere in our societies. Apart from that, has it ever seemed a good idea to have your elderly being taken care of by Arab wealth funds? When basic human needs are opened to the market places of a perennial growth economy, there is only one possible outcome.

Whether it’s food, water, health care or elderly care, sooner or later the profit principle will make people dispensable, since financiers are bound to find a more profitable way to invest their money. A true and well-deserved symbol of what our societies have come to.

Perhaps stories like these will wake up a few more people to why I put the emphasis on the world of finance as the most perverse and perverting influence on the planet today. Energy and the environment finish a distant 2nd and 3rd in that assessment.

Twelve days ago, the senior management of Britain's second biggest care home operator, Four Seasons Healthcare UK, received the news they had been dreading.

The nursing home giant's finance director Nick Mitchell e-mailed chief executive Dr Peter Calveley and other senior managers to say emergency rescue talks between Four Seasons' owner, a Qatari sovereign wealth fund, and its main lenders, including Royal Bank of Scotland, had completely broken down.

And Four Seasons is not the only operator in trouble in the nursing home and disabled residential care sector. The businesses - many of them private equity-owned - which look after some of Britain's most vulnerable people, are struggling in the face of the credit crisis and some are teetering on the brink of bankruptcy.

The biggest player, Southern Cross, breached its banking covenants this month and many of the smallest, most old-fashioned businesses in the sector are finding life even harder and are expected to close. What Mitchell's e-mail meant to management of Four Seasons is that they are on their own.

The chain, which is already in breach of its banking covenants, could go bust if it fails to agree a re-financing deal by September 1. If it looks like a deal cannot be agreed, Four Seasons' management may even act at some stage to put the company into administration themselves.

And the chief executive of the care home operators' trade body English Community Care Association, Martin Green, warns the problem could be much more widespread. "It's a possibility that some operators will go bust. Everybody's suffering at the moment," said Green. "If we don't get some remedial action we will be in a crisis. We're having severe difficulties now and Britain is going to need a lot more residential care in future."

Yet just six months ago, Southern Cross - formerly owned by private equity house Blackstone - was the darling of the stock market and few outside the sector had a sniff of the current troubles at Qatar Investment Authority (QIA)-owned Four Seasons.

So what has gone wrong in such a short space of time? "It's not very magical. In the long term, demographics mean this is a good sector to be in. But guess what? If you borrow too much, you are totally f*****," said one adviser working in the sector.

"There was tons of M&A over the last couple of years. It was all pass-the-parcel stuff, putting ever higher levels of debt onto these businesses and now, frankly, the music has stopped," he added. Assessed through post-credit crisis eyes, the financial structure of the Four Seasons buyout meant that the current carnage was always an accident waiting to happen.

The QIA's UK frontman Paul Taylor bought Four Seasons from the private equity arm of Allianz in 2006 when debt was still cheap and plentiful. Of the £1.4bn purchase price, just 8 per cent was equity from the Qataris. The financial engineering designed by Taylor's fund Three Delta was considered incredibly aggressive, even by the standards of the cheap debt-fuelled buyout frenzy reaching its apogee at the time.

Despite this, the QIA might have been able to agree a deal with lenders had Taylor - who has recently parted company with the Qataris - not made one fundamental mistake: he borrowed the money to buy Four Seasons on a two-year fixed-term deal, believing the good times would never end and he could re-finance the acquisition with better terms.

But then the credit crisis hit. Property prices have plummeted and the QIA could not find banks willing to re-finance the business. Private equity houses and property investors have piled into the broader healthcare sector in the last few years. For instance, private equity also owns rehabilitation centre to the stars, The Priory, which was bought out by ABN Amro's private equity arm, then inherited by RBS when it led the ABN Amro takeover last year.

The QIA itself owns a much bigger portfolio of assets connected to the sector. The oil-rich sovereign wealth fund, which also owns a quarter of J Sainsbury and is set to buy a big stake in Barclays bank, made its earliest investments in the healthcare sector, snapping up NHP, a property investment fund that manages care home properties and specialist care chains Care Principles and Senad.

But last month, the sovereign wealth fund appointed Ernst & Young to restructure its entire debt-laden £3bn healthcare and property portfolio. One idea RBS discussed with the QIA's adviser Credit Suisse was that the bank might buy some of those assets as part of a re-financing deal and crunch them together with The Priory, but that idea is now thought to have been shelved.

Ilargi: Part 2 of a 4-part series on how America botched its future electricity supply.

Leading Wall Street electric utility analyst Dan Scotto predicted U.S. electric rates will double within five years due primarily to lack of supply. The increase will be on top of a 25% rate rise Americans have had to endure over the last few years, he said.

In Part 2 of his exclusive four-part interview with EnergyTechStocks.com, Scotto said virtually all regions of the U.S. will see rates double, the exception being California, which he said has already experienced much of the increase still to be felt by the rest of America.

Scotto said that, just as global oil supplies aren’t keeping up with skyrocketing demand, power plants aren’t being built fast enough in the U.S. to keep up with rising electrical demand. Moreover, just as aging oil wells become less productive, America’s power plants are becoming less efficient as many near the end of their economic life.

Scotto said new power generation technologies being counted on, such as wind power, are more costly than coal and nuclear power. Also, they are still essentially unproven technologies susceptible to mechanical failures.

Asked how this situation could be allowed to develop, Scotto said the deregulation of the U.S. electric utility industry had resulted in power reliability becoming a local political issue. He forecast that not until there is an “event,” meaning a blackout, will elected officials take the politically unpopular step of beefing up supply by approving new power plants and transmission lines

It is ironic that the Arabian Gulf, which contains two thirds of the world’s proven oil reserves and is the epicentre of the energy business, faces a regular gas shortage, possibly as high as 7 billion cubic feet in the next decade. This is going to have a seismic impact on the GCC’s oil production, consumption and exports, a major factor in crude oil prices.

Only Qatar among the GCC states has the scale of reserves, production and infrastructure to ignore gas supply constraints in industrial production in some of the highest nominal GDP growth economies in the world. Cheap energy is the feedstock for many of the GCC’s industrial diversification strategies, such as the giant aluminium smelting companies of Dubai and Oman or Saudi Arabian downstream petrochemicals venture at Yanbu. Gas, in particular, powers the electric utilities, aluminium, fertiliser and water desalination plants in the GCC.

These industries are the backbone, the very DNA of the Gulf’s new twenty first century industrial constellation. Electricity demand in the GCC is growing at as high as 10 per cent a year, higher than China, thrice the growth rates of the West. Water desalination plants are literally a matter of life and death for the new economic complexes in the Arabian Desert. Yet the Gulf’s industrial future is now threatened by a gas supply deficit only aggravated by some of the most generous gas subsidies in the world.

Gas was traditionally a poor cousin to crude oil in the Gulf, suffering from chronic underinvestment in the 1990’s because there was simply no financial incentive to upgrade infrastructure at a time when oil prices had crashed to $10 a barrel and Asia’s currency meltdown threatened both oil and gas gluts for GCC gas. Yet the last decade has witnessed a spectacular U–turn in the world gas market.

Oil prices have soared from $20 to $135 a barrel in only five years as demand from the emerging, energy extensive economies of the Pacific Basin coupled with geopolitical shocks as diverse as war in Iraq, sabotage in the Niger Delta and strikes in Venezuela created the perfect storm for the world’s third oil shock since 1973. This has meant a seismic change in the economies of GCC gas production, export and pipelines.

Moreover, the development strategies of the Gulf have emphasised energy and capital intensive for downstream petrochemical industries, which increasingly require various grades of sour gas and condensates. This is the reason Saudi Arabian annual gas production has tripled to almost 90 billion cubic meters since the Iraqi invasion of Kuwait in 1990.

Access to cheap reliable gas supplies is increasingly becoming as critical an ingredient as access to syndicate international bank credit for the success of the new downstream energy industries in the Gulf. The Saudi Gas Initiative has not lead to any increase in proven gas reserves and Total, France’s oil supermajor, has pulled out of the initiative, selling its stakes to Shell and Saudi Aramco.

Since Total’s abandonment of its Saudi gas exploration projects in the Kingdom’s Empty Quarter, Saudi Arabia could well face the surreal prospect of becoming a gas importer in the next decade. Twilight in the desert could well be gas, not oil for the Kingdom that has acted as Opec’s swing producer, the proverbial central bank of black gold, since Sheikh Yamani’s tenure as Saudi Oil Minister in the 1970’s.

The gas deficit has compelled Oman to construct coal fired power plants and the UAE to use expensive crude and diesel liquids for power plants and the UAE to use expensive liquids for power generation during periods of peak summer air conditioning load times. The Dolphin Project is the largest cross border venture in the GCC, helping to bring Qatari oil to the UAE market.

However, Qatar cannot supply the sheer magnitude of the gas demand that will arise from the lower Gulf’s power generation, aluminium smelting, water desalination, petrochemicals and iron ore industries. Qatar has even declared a moratorium on new projects in the North Field till 2010, an ominous indicator of a future GCC gas squeeze.

While Qatar and Iran have some of the world’s largest gas reserves, Iran is prevented from US Treasury sanctions from the billions of dollars in international bank credits from converting its gas into viable new production and supplies. Regional politics preclude Iran from emerging as a significant gas supplier to Saudi Arabia and the rest of the GCC. The gas supply deficit in the region could well provide both the impetus and strategic opportunity for the evolution of a nuclear power industry.

The worldwide shortage of gas exploration assets, equipment and personnel means the Gulf states have to dramatically rethink their economic growth and industrial models of the future as power generations rates surge. Sour gas, the Gulf’s primary geological gas assets, also is corrosive and inappropriate for the state-of-the-art downstream industries now emerging in the region. This prevalence of sour gas is the reason the UAE, blessed with the world’s fifth largest gas reserves, imports gas from Qatar in the Dolphin Project.

Other than US Treasury sanctions against Iran, “resource nationalism” in the Gulf also prevents significant foreign investment in regional gas production. For instance, the Kuwait Parliament has vehemently opposed granting foreign oil companies any equity in its domestic oil and gas business.

Since Big Oil has no stake in Kuwaiti oil reserves, its incentive to transfer the latest gas exploration technology is simply not there. Technology, cost, geopolitics, water, power, petrochemicals and project finance will also define the evolution of the Gulf’s gas industry in the next decad

Slowly, reluctantly, Western G7 economics professors are being forced into admitting that China is doing something RIGHT. Hitherto, almost all commentary about China has been based on the stupid, ideologically insane premise that China was flubbing everything and the Chinese are very, very stupid or foolish or easily tricked economic children who are easy for us to CHEAT.

This ridiculous and stupid template has been used by nearly everyone from top to bottom. In the US Universities, it is a religious doctrine that the Chinese are infantile, foolish and naive and the West is clever, cool, exploitive and far-seeing. Reality is exactly opposite!

This is the definition of 'hubris'. Since the first day I launched my own analysis of the news, I have mocked this pretension and warned everyone that the Chinese are far from stupid. They are indeed, intensely intelligent, collectively and individually. They are an awesome force in the intellectual landscape. Since so many are Americans, we tend to overlook the fact that they come from the Chinese culture. And this culture is merging with our Anglo-Saxon/Germanic culture. And a good thing, too! About time! We need this badly!

One example of the intense stupidity of US commentary about China is the whole business of China's FOREX reserves: everyone yapped here in the US, 'Holding and growing big FOREX reserves is stupid.' I challenged this infantile analysis with charts, graphs and thousands of words talking about how FOREX reserves are how trade partners with the US control relative values of their floating currencies with an obviously sinking dollar.

And they do this for trade benefits! And we should stop them from doing this. But the campaign in the West to convince China to stop doing this failed. The IMF, World Bank, BIS and all the central bankers in the G7 including, amusingly, Japan, all tried to convince the Chinese that building a trillion dollar plus FOREX reserve was stupid. But Japan continued to build its own reserves and so China laughed at this con job by the G7 and continued forwards.

It amuses me tremendously to see that a professor finally figured out that China has a 50 year plan. Congratulations, Carnegie Institute! ABOUT TIME, GUYS!!!! This is what happens when the US media buries commentators like myself. If I were on the news every week since 1984, why everyone in America would know very thoroughly all about the secret Chinese 50 year plan hatched back then. Today, we would be fully aware of the danger of free trade and why it could not be allowed. We would be taking severe measures to protect ourselves from going into debt to the Communist Chinese!

Instead, I was told to go jump in the lake and today, the US, not I, is drowning in a sea of red ink and the only entity capable of rescuing us is Communist China. And they will rescue us! For a price. As the Chinese figured back then, 'It is worth a trillion dollars to bankrupt the US and then be the bankers.'

Or as Shen put it, 'I BE bank!' with his sardonic, short laugh. 'Ha. Ha.' Shen, by the way, was very much a gnome. He came to my house waving Mao's Red Book and left it rubbing his hands with glee, once he learned that women overlook everything if enough money is waved in front of their pretty goddess eyes.

Back the the smart professors who learned the truth about 30 years too late: I figured, eventually they would learn. After all, they are all very smart people. Smarter than I. So eventually, even obvious things will be noticed if they banged their toes against it enough times!

When the Communist young upcoming leaders lived with me, I was stunned at the speed at which they picked up the business of real capitalism, US trade weaknesses, how to bribe US officials and how to manipulate the US media. They came to my house knowing nothing about profits, how to handle money, what money meant, they really were 'naive'. And learned fast as lightning, how to make, find and use money!

This includes daily howls from me concerning the real nature of inflation. I must have said an awful lot about that back then. Note how the Chinese took inflation far more seriously than the US this last year. Relentlessly, the government has raised banking reserve requirements and strangled the inflow of foreign funds. This is why they increased their FOREX reserves to now almost $2 trillion.

This is over their target. But they are flexible. They can see the US and Japan are set to ignore inflation at home and are bent on exporting inflation to China. So China is no longer 'growing' its trade surplus with the US and Japan. The recent earthquakes in China has also given it more impetus to invest internally, anyhow.

By the way, I won't even link to the lastest 'bash the Chinese' garbage from the NYT. As usual, the Times puts the ugliest gloss on generosity and kindness. The government of China is being criticized internally and correctly so, for the tragedy of all those schools collapsing. This horror can't be ignored. So the Chinese government is now giving out death benefits to the families who suffered this greatest of losses.

In the US, we can't boast because we still won't rebuild New Orleans. The residents were scattered to the four winds and we ignore them today. And now, this year, we can plainly see, we will have ferocious hurricanes! And the looming Great San Andreas Quake will come and we can't afford to rebuild and lord knows how many children will die when that hits!

Few nations pay families for losses of members in natural disasters. The very richest might do this but ONLY if the numbers are small. And frankly, the losses in China per capita from that latest blast from Mother Nature is a vanishingly small statistic compared to the population. Even the Great Boxing Day Quake and Tsunami barely changed the population growth statistics of Southeast Asia! Half a million out of several billion is a drop in the bloody bucket.

This has to be remembered when we consider these things. China is a HUGE market. Even with the death of 67,000, it still grows by this number every week due to births. Americans can't even begin to imagine the fertility of Asia. Japan is the exception.

Due to cruel economic policies which the US is now actively imitating, the birth rates there have utterly collapsed. The same is true in Europe. The G7 nations are seeing a birth crisis of huge proportions. Only South America and Central America are still seeing a growing birth rate. And these areas are still quite poor.

Ilargi: Oh, yes, grasshopper. in a different time, India and China would have had a chance to bloom. But not now, they’re too late: their dreams will shatter when they hit the walls of debt, diesel and dämmerung.

Authoritarian regimes often yield strong short-term economic results, as seen in Germany in the 1930s, the Soviet Union in the 1950s, Brazil in the 1960s and China in the 1990s.

Unencumbered by such things as property rights, legal recourse and public debate, the authoritarian regime can harness significant economic and political resources to achieve impressive industrial and economic feats. Conversely, democratic regimes tend to be sloppy affairs with loud public discourse, a vocal press, stubborn land owners and a myriad of civil liberties.

Far from being able to harness economic resources, the government often must act more as a regulator. The result is that there are very few grandiose government-sponsored projects. Instead, there are countless private-sector initiatives driven by the invisible hand of the market. But while the authoritarian regime is envied by some, the fact is that, longer term, this type of socio-economic model has typically led to economic and social distortions.

That is the dilemma faced by China today. Since the 1980s, the government has focused on developing an export-driven economy supported by an artificially undervalued currency. Foreign direct investment was encouraged while domestic consumption was limited. Massive infrastructure projects were initiated, fuelled by a growing trade surplus, with cities sprouting up in the hinterlands like mythical phoenix.

For years, the Chinese economy benefited from these policies with double-digit growth in gross domestic product, vast foreign currency reserves, and ever-increasing capital inflows. But now the economic and social distortions have begun to appear with rising inflation rates, numerous asset bubbles, looming overcapacity and rampant institutionalised corruption.

China's rulers find themselves in a quandary. If the government allows its currency to appreciate rapidly to reduce inflation, it will drive down exports and fuel unemployment. If it fails to quell inflation, social unrest will quickly unfold. But while the hare runs into obstacles of its own design, the tortoise is looking well placed in the long endurance race for competitive advantage.

In India there is an entrenched and vibrant democracy that will ultimately drive it to outperform China socially and economically. Messy, frustrating and more often than not agonisingly slow, India's democracy would seem chaotic at the surface. But if you look deeper, you will see why the tortoise will prevail. Let's take a look at two of the big advantages that India's democracy provides.

As India becomes urbanised, many families will choose to sell or borrow against their land so that they can start businesses, buy apartments or provide education opportunities for their children. India is at the start of a gradual migration driven by the development of high-end manufacturing and other "sunrise" industries that will require a vast pool of skilled and semi-skilled labour.

This migration will create an increasingly urban India that is expected to attract more than 200 million rural inhabitants to "secondary cities" by 2025. This transition will facilitate the sale of land holdings by an estimated 30 million farmers and 170 million other individuals indirectly tied to the agricultural sector.

These sales are expected to generate more than $1 trillion in capital by 2025. This capital will have a multiplier effect on the Indian economy that could exceed $3 trillion. The development of mortgage-backed security and asset-backed security markets, driven by financial institutions like Citigroup, will create the liquidity required to free up this capital.

China, by contrast, has no rural property rights. The 750 million rural residents who lease land are at the mercy of local and regional government as to what compensation they will receive, if any, when they are forced from the land as a result of development, infrastructure improvements etc. Additionally, they have no right to borrow against their lease, and as such they have no assets.

In fact, the Chinese government's official figures state that more than 200,000 hectares of rural land are taken from rural residents every year with little or no compensation. Between 1992 and 2005, according to some estimates, 20 million farmers were evicted from agriculture due to land acquisition, and between 1996 and 2005 more than 21 per cent of arable land in China was put to non-agriculture use.

The result has not been unexpected, with over 87,000 "mass incidents" (or riots) reported in 2005 – a 50 per cent increase from 2003. Many provincial governments in China have begun to use plain-clothes policemen to beat, intimidate or otherwise subdue any peasant that dares to oppose these land grabs. And, also as would be expected, the beneficiaries from these policies have been developers and corrupt government officials.

This is a cornerstone of any modern society. India has a legal system that has been in place for well over 100 years. It is internationally respected and includes laws that protect intellectual as well as physical property.The rule of law creates predictability and stability, allowing entrepreneurial behaviour to flourish.

This is clearly evident in India, with more than 6,000 companies listed on the stock exchanges, compared to approximately 2,000 in China. More telling is that of these 6,000 listed groups in India, only 100 or so are state-owned. This stands in stark contrast to China, where more than 1,200 belong to the state. Can there be any doubt where the next Microsoft or Intel will be created? Certainly not China.

More than 100 Indian companies that completed initial public offerings as mid-cap firms now have a market capitalisation of over $1bn (£500m). Companies such as Jet Airways, Bharti Tele-Ventures, Infosys, Reliance Communications, Tata Motors (which just acquired Jaguar), Wipro and Hindalco are becoming multinational competitors with globally recognised brands.

China also has numerous companies with a market capitalisation of more than $1bn, but most of these are state-owned behemoths recognised for their sheer size and not their nimbleness. When the rule of law is seen by investors and foreign companies as something that is beyond question, it serves to facilitate additional investments in research and development.

For instance, 150 of the top global companies now have research and development bases in India. Additionally, the US Food and Drug Administration has certified more companies in India than in any other country outside the US, a testament to the innovation fostered by free markets and the rule of law.

China, meanwhile, has a legal system that does little to protect intellectual and physical property rights; it has been ranked with Nigeria in this respect. Indeed, China's illegal copying of movies, music and software cost companies $2.2bn in sales in 2006, according to an estimate by lobby groups representing Microsoft, Walt Disney and Vivendi.

This figure may in fact be understated as it does not include pirated products that have been shipped to overseas markets by government-controlled Chinese companies. The rule of law, when applied evenly and justly in a democratic society, also helps to ensure that wealth accumulation does not favour individuals in political office or people connected to those in political office.

Democracy is a messy thing, especially when you have an electorate that exceeds 600 million motivated voters. However, it helps to ensure that individual liberties are respected and that the government is responsive and beholden to the will of the people – rich or poor. A democracy also ensures accountability through impartial courts that help enforce and protect such things as property rights, environmental rights, human rights and good governance.

India's democracy is far from perfect but it is also quite young, and as incomes rise and the populace becomes more informed, we can expect that India's state institutions will become more responsive and transparent.And what about the hare? Consider this: a recent survey found that of the 20,000 richest men in China, more than 95 per cent were directly related to Communist Party officials. Where would you place your bet?

19 comments:

el pollo
said...

Bigelow,

In one of your postings yesterday, you stated that it was now illegal to keep currency in a bank safety deposit box. In a brief Google search yesterday, I could not find this, but rather found in some lawyer recommendations, by inference, that it was not. So could you give us a reference for this information?

In trying to ascertain coming events, I have been trying to learn about the Great Depression in economic terms. But the United States treasury had little or no meaningful debt when it started while we have crushing debts and obligations (for those of us who chose to remain in the USA) today. I think this difference is huge and makes the GD v. 1.0 a somewhat meaningless template for things to come. (Just a non-economist trying to make sense of this catastrophe.)

I-I know you've said you're not a Bill Gross fan, but his August commentary starts out "The deflating U.S./global asset markets are much like Churchill’s Russia". At least he admits we are in deflation, unlike many. He essentially says the gov. is trying to prop up the housing market at all costs and if it fails to do so it's all over. When Bill Gross advises that one should be in T Bills right now that is a dire day.Kalpa

I searched for info on cash in safety deposit boxes and found none other than it is unlawful to keep STOLEN cash in a safety deposit box! Looking forward to the answer, Bigelow, and thanks el pollo for asking the question.

No link. The reason it stuck with me was because it was so unusual: what do you mean it's illegal? I habitually read 10-15 sites a day plus extras and my references file is unmanageable. Why don't you ask a bank manager?

Bigelow said yesterday: It’s illegal to keep cash in a bank safe deposit

Bigelow said today (I think referring to that cash held in a safely deposit box) : what do you mean it's illegal?

Normally I would angrily say: Just what do you mean Bigelow!- But there is a great idea for me in this- from now on I will call my flawed memory my unmanageable reference files. So instead it is " mucho gracias Bigelow:)".

Thankyou. My memory is not flawed I simply can not provide an internet link. I should argue it is a detail in the face of the greater argument not to keep anything of value where the growing government culture of confiscation can relieve you of it. FDIC Spring 1997

“Money Laundering Red Flags

• Large amounts of cash maintained in a safe deposit box. A customer may access the safe deposit box after completing a transaction involving a large withdrawal of cash, or may access the safe deposit box prior to making cash deposits which are just under $10,000.” Section 8.1 - Bank Secrecy Act, Anti-Money Laundering and Office of Foreign Assets Control

“How to get the information yourself:Visit your bank, ask a few well-worded questions, being careful not to arouse suspicion - if that doesn’t work, talk to friends and other family members - maybe they’ve heard something - or as a last resort, just point blank call the bank manager in private and demand to know what’s all this business with the Homeland Security deciding what I can have from my safe deposit box - tell me now or I’ll close my account today.I’ll bet if you put forth the effort you’ll get the answers you want.” Homeland Security To Confiscate Bank Safe Deposit Box Contents

Z,Just personal income increase against the government posted rate (in Canada). The point I was trying to make was that it would be at least 2.4 times as onerous for me to buy now, and at the seemingly generally accepted multiplier of 3.5 it would be 1.7 times as monetarily onerous. ( BUT there I have not factored in, that, that would be considered an upper level of repayable mortgage debt, therefore be some unknown,to me,factor more onerous than that numbers would have one believe.

I guess, what I am really on about is, that ilargi is probably 'tops on' for getting it right on how far things will drop. Lots and lots! Glad to see by your comments about the real inflation rate that you agree:-)

Bigelow,

Good to hear that your clever old memory is full bodied intact. That news of yours has cleared the sombre vision in my anxious mind. Oh, my dear, the visions I had of yours truly, sadly slumped with eyes lolling in their sockets as synapses snapped in vain cerebral searchings, were desperation incarnate.

More seriously Bigelow, about The invasion of the safety deposit box, you might be getting ahead of the game. Not wrong , just ahead. At the moment I would worry more that a bank closure meant that I would be unable to access my safety deposit box for some period. I am unfamiliar with laws concerning search and seizure in the US, but would guess very strongly that without some sort of judicial warrant, unless, of course, they start wrapping donuts in them, it would not happen. But I could be wrong and in that case maybe the hollow log would be a best bet. I am readying my metal detector and sharpening the nose of my dog 'Sniffer' for just such an eventuality.

I took a look at that FDIC link you gave and brought this back about Red Flags for money laundering:

Safe Deposit Boxes

* Frequent visits. The customer may visit a safe deposit box on an unusually frequent basis. * Out-of-area customers. Safe deposit boxes may be opened by individuals who do not reside or work in the banks service area. * Change in safe deposit box traffic pattern. There may be traffic pattern changes in the safe deposit box area. For example, more people may enter or enter more frequently, or people carry bags or other containers that could conceal large amounts of cash. * Large amounts of cash maintained in a safe deposit box. A customer may access the safe deposit box after completing a transaction involving a large withdrawal of cash, or may access the safe deposit box prior to making cash deposits which are just under $10,000. * Multiple safe deposit boxes. A customer may rent multiple safe deposit boxes if storing large amounts of currency.

So if you plan to use a box don't do those things and you will likely be safe as houses storing your ill gotten gains in such a place. Until of course ... ?!

And yet, it costs 1.2 quadrillion Zimbabwean dollars to buy a laptop. WTF? How does this end for Zimbabwe?

Rule no. 1 in hyperinflation: there's no such thing as "present tense". The time it takes you to type in those two words just cost you a million zwops.

Similarly, the time when a laptop cost $1.2 quadrillion ZIM? That's now the lore of folk songs about the good old days, favorite chanting material at camp fire parties where a single log on the fire costs $12 quadrillion when you throw it on, and $100 brazillion when it's done.

Mugabe loves this: he's made sure he gets US dollars, renmimbi and Euro's, which get more valuable by the minute. He gets richer every single second of every single day.

Speaking of "desperation incarnate", it took the entire day for me to remember a relation's lawyer's name. Sure I could look it up but I insisted my memory do the work, I didn't need it straight away.

But Seriously, with the Patriot Acts 1&2, I believe it is the Military Commissions Act and of course the catch all for profits and illegality: the Drug War, a general loss of the rule of law has taken place in the U.S. Police can seize your cash if you can't prove right there how you came by it, i.e. receipts. What is to stop them from seizing the receipts too?

The Patriot Acts were expanded and extended indefinitely, there are average people on enemies lists thanks to data mining and it may be up to some computer program if you have been placed on these persons of interest lists. All your communications can be routinely tapped into by multiple government agencies some I'm sure we've never even heard of.

If the internet has become the last holdout of free speech in a controlled media universe you can be sure it too is closely monitored and at some point it will be censored, long before it runs low on electricity.

For Zimbabwe, the international debt financing model is already mostly dead. I'm no expert on the country by any means, but if they have a conventional central bank, I doubt very much that it is a private entity owned by venerable international banking families and holding real value worth defending. It would more likely be a political pawn of Mugabe's, intent on maintaining his ability to use the wealth of the entire country as his personal piggy-bank.

Zimbabwe has been living through a currency hyperinflation, not a credit expansion. Credit expansions are self-limiting and eventually implode. Any attempt to increase liquidity into the teeth of credit deflation is doomed to fail, as any liquidity generated would be taken off the table very quickly by anyone in a position to do so. (Paul Krugman had a readable illustration of this in The Economics of Depression.)

Cash hoarding is the order of the day, for banks and other entities. Lending is shut down, which reduces liquidity dramatically thanks to the leverage inherent in fractional reserve banking (ie hoarding reduces lending by at least ten times the amount hoarded, and quite possibly more as reserve requirements have been whittled away in recent years).

Restoring liquidity is not possible in the absence of confidence (ie confidence in the stability of the money supply, without which hoarding will continue). Such confidence will not be restored until the deleveraging has proceeded to its logical conclusion - where the outstanding debt is acceptably collateralized according to the remaining creditors.

The force and speed of credit collapse (once a tipping point has been reached) can outpace attempts to monetize debt or print currency, as the latter (as cumbersome public responses to an ongoing crisis) only occur with a time lag. That time lag only widens the confidence gap, making it less an less likely that any measures taken can succeed.

The presence or absence of a lender of last resort makes a difference in terms of the depth of a financial crisis following a build-up of credit (see Charles Kindleberger's Manias, Panics and Crashes). If such a lender is ultimately available, confidence can be restored much more quickly and a complete deleveraging need not occur.

Unfortunately for the world, the current credit bubble is so massive and so international that time lags are much longer due to the need for international coordination, priorities may differ between countries so cooperation is less likely and the spread of contagion more likely, some countries (eg Iceland) are in so far over their heads that their banks would have to be bailed out by other jurisdictions, and, ultimately, no one has deep enough pockets to bail the derivatives market anyway. For these reasons, deleveraging is likely to occur to a much more devastating extent than in previous crises.

I basically agree with bigelow about the insecurity of safety deposit boxes as banks fall like flies in a Raid commercial. We no longer operate under the rule of law. The Congress (Democratic majority mind you) passing the telecom retroactive immunity act was the death kneel for rule of law as the F&F bailout is the death kneel for the economy in general.

I was just surprised to learn that it was, de facto, illegal to store currency in a SDB, and apparently this is incorrect. However, Vaterland Sicherheit is very involved in "giving direction" to bank managers, and we have probably reached the point where the hollow log is safer. Since Stoneleigh says that short term treasuries and currency are the safest places to attempt to store wealth, this is an area of concern to all of us.

Keeping cash in a safety deposit box is not allowed in Canada, and I doubt very much whether it would be in the US or elsewhere either. In any case, it wouldn't be a good idea whether you could get away with it or not (and you probably could for the time being). The more creative you are with wealth storage, the better your chances of hanging on to it, and a safety deposit box is not a creative option.

Apart from the potential to lose access during a systemic banking crisis, safety deposit boxes are the first place authorities would be inclined to look. During the depression, people were marched up to their safety deposit boxes where gold was confiscated without compensation, after private ownership of gold became illegal.